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MacroS04-3
Question from Past Macroeconomics Qualifying Exam Spring, 2004 - Question three- at George Mason University The relationship between the rate of price inflation and the level of unemployment is one of the central issues in macroeconomics: *a. What is the observed short-run empirical relationship between these variables for the United States? *b. How well does this observed relationship correspond with the predictions of each of three alternative models with which you are familiar? *c. Which of these three models, in your view is the best and why? *d. Does your answer to "c." provide any short-run policy implications for reducing the level of unemployment? *e. What is the observed relationship between inflation and unemployment in the long-run? How does it differ (if at all) from the observed short-run relationship? *f. Which of your three models best explains the long-run relationship and why? Answer *a. Philips Curve: For short-run (and somewhat unanticipated) changes in the rate of inflation there seems to be a negative relationship in the change in rate of unemployment. For the long-run (and for short-run anticipated changes) there empirically is no relationship -- prompting macroeconomists to advance the theory of the N.A.I.R.U. (Non-Accelerating Inflation Rate of Unemployment - a vertical line at some rate of unemployment, between 4.5% and 6% of the labor force, in the US). : alternative answer There is a short-run trade-trade of between unanticipated inflation and the unemployment level (as a percentage of the labor force). The direction has been seen to be negative and diminishing with higher rates of inflation. *b. 1) The Barro-Gordon-Kydland-Prescott model shows that with discretion a central authority issuing money will be trapped into a positive and non-zero rate of inflation because both thy and the public realize the temptation to take advantage of suprise short-run trade-offs, such that a creditable inflation rule which is lower than this rate might be helpful. For all purposes discretion does not exist (because of the trap) to the extent that the central authority and the public have the same maximizing function (lower unemployment and not much adversity towards inflation). : ~ 2) The fear of hyper-inflation (Seignorage as a form of "invisible" tax). : ~ 3) Tobin (1972) suggests that since firms have a problem cutting nominal wages inflation eases this burden while the real wage is eroded and the nominal wage can be held constant. This assumes a fundamental asymmetry, the public sees the cost of inflation in the prices they pay for goods, but not in the wage they are receiving. (Romer 2006, p. 551) : alternative answer: What Three Models? -- (Friedman's N.A.I.R.U. ; Traditional Phillips Curve; Keynesian)? *c. Since Barro-Gordon 1983, the movements in inflation as an attempt to lower employment have become less common. This could have been the result of the Volker / Regan recession of the early eighties as well, as higher rates of unemployment in the short-run were tolerated in order to get the 17% rates of inflation down to a more reasonable level. However, this new insight into the perverse incentives of the central authority has since been effective at convincing the monetary authorities to be more conscientious about the impact of short-run policy goals on long-run economic conditions. *d. The trade-off for short-run unemployment reductions is macro instability in the long-run. Suprises are the only way of getting this trade-off and if the bank shows that it is wiling to make this gamble, people will assume that the gamble will be made constraining the bank to doing it unless higher-than-normal unemployment is tolerated to prove creditability. *e. The long-run relationship is a vertical or N.A.I.R.U. as disscussed earlier. *f. Again, the Barro Gordon paper shows how the options of the fed, the locus of highest acheivable indifference curves and short-run trade-offs, and the public objective functions -- both match and will "trap" the central bank at a positive rate of inflation and the same "natural" rate of unemployment (as a function of price-level expectations). : Alternative answer -- Friedman Answer *(a) There is a short-run trade-trade of between unanticipated inflation and the unemployment level (as a percentage of the labor force). The direction has been seen to be negative and diminishing with higher rates of inflation. *(b) Classical, Rational Expectations, and New Classical do not predict that this relationship should hold. This would be more favorably represented in all the schools of thought which subscrive to some sort of Nominal Price Rigidity, including Monetarists, Keynesians, Neoclassicals (and the synthesis), and New Keynesians. Sources * Romer, David. Advanced Macroeconomics, 3rd edition. McGraw-Hill. 2006 * [http://links.jstor.org/sici?sici=0002-8282%281972%2962%3A1%2F2%3C1%3AIAU%3E2.0.CO%3B2-5 Tobin, James. Inflation and Unemployment The American Economic Review, Vol. 62, No. 1/2. (1972), pp. 1-18.] * [http://links.jstor.org/sici?sici=0022-3808%28198308%2991%3A4%3C589%3AAPTOMP%3E2.0.CO%3B2-I Barro, Robert J. and David B. Gordon. A Positive Theory of Monetary Policy in a Natural Rate Model The Journal of Political Economy, Vol. 91, No. 4. (Aug., 1983), pp. 589-610.] Stable URL: Other Questions * Next MacroS04-4 * Previous MacroS04-2 * Other Macro Prelims